Explanation

Effective duration is the most appropriate measure for this portfolio because:

1. Callable bonds have embedded options - the issuer has the right to call the bond before maturity. This option feature makes the cash flows uncertain and dependent on interest rate movements.

2. Asset-backed securities (ABS) typically have prepayment risk, where borrowers can prepay their loans, affecting the timing of cash flows.

3. Effective duration accounts for changes in expected cash flows due to changes in interest rates, making it suitable for bonds with embedded options or uncertain cash flows.

Why not the other options?

• Macaulay duration measures the weighted average time to receive cash flows, assuming no changes in cash flow timing.
• Modified duration adjusts Macaulay duration for yield changes but still assumes fixed cash flows.

Both Macaulay and modified duration assume fixed, non-contingent cash flows, which is not appropriate for callable bonds and asset-backed securities where cash flows change with interest rates.

Key takeaway: When dealing with bonds containing embedded options (like callable bonds) or securities with uncertain cash flows (like ABS), effective duration is the preferred measure as it accounts for how cash flows change with interest rate movements.